Frank Haines, Chief Investment Officer, Comments on Current Market Volatility

June 25, 2013: There has been a spike in financial market volatility in June, attributed to the potential for the unwinding (“tapering”) of Federal Reserve policy on improved economic data, as well as credit tightening and a sharper slowdown in China’s growth than markets expected.

Whether either explanation is the correct one, since May 31st the S&P 500 has fallen about 2.6%, the MSCI EAFE index by 4.8% and the Barclay’s Aggregate Index decline is almost 1.9% at the time of this writing.

What appears to have caused the severity of the market sell-off has been several factors. Leverage has steadily risen over the past year for both bond and stock managers, as the expectation for low absolute yields into 2014 or 2015 and a steep yield curve encouraged carry trades (borrow short, invest long). With the unexpected back-up in rates, these leveraged trades unwound. Additionally, as MBS durations lengthened by over a year (as measured by the Barclays Mortgage Index), managers sold Treasuries to shorten overall duration, adding to the Treasury sell-off.

Margin debt and leverage also contributed to weakness in equities, based upon the reversal of long-standing assumptions about Fed policy. For U.S. stocks, it was likely that some investors simply locked up strong year-to-date gains on the first signs of weakness. Weakness in emerging markets was evident in a number of financial headlines, which included: sharply rising borrowing rates in China as their Central Bank attempted to reduce leverage in the shadow banking markets; political unrest in Brazil, Turkey and South Africa; and softening in EM currencies. European markets, previously calm, weakened on deepening recessions and new concerns over the absence of possible next steps to moderate austerity and encourage economic growth.

Despite some improvement in housing data and some manufacturing sectors, U.S. economic growth is far from robust enough for the Fed to substantially reverse its quantitative easing program. Inflation remains below the Fed’s targeted 2%, and unemployment is well short of the stated 6.5% goal. In short, conditions remain disinflationary in most developed markets, offering little likelihood of interest rate pressures on that front. In fact, TIPS (bonds designed to protect against inflation) have been very weak in June, as real yields have risen to positive for the ten year TIP; this reflects a decline in implicit inflation from about 2.4% a month ago to 1.9% currently.

Bonds have captured the most headlines, as the 10-year Treasury yield has risen over 50 basis points (as of June 24th) since the end of May. Corporate bonds have fared even worse as spreads have widened by roughly 60 basis points (i.e., Barclays Credit Index). Corporates, as well as taxable municipal bonds, are also under pressure from tight liquidity conditions, as dealers maintain little inventory and quote large spreads between bids and offering prices. MBS have also suffered, particularly lower coupon (3% to 3.5% coupon) issues, which have extended in duration as they have been the focus of the Fed’s open market purchases under its Quantitative Easing program. Mortgages suffer from highly negative convexity – that is, they perform worse than Treasury or corporate bonds with significant interest rate moves – and the combination of a Fed pullback from purchases coupled with the prospect of the beginning of a secular rise in interest rates was quite negative for the lower coupon issues.

The sell-off may reflect a turn in investor sentiment, as investors who have extended for yield in this low yield – and apparent low risk – environment have witnessed how rapidly the situation can change. There is a good case that the sell-off is overdone, as it has essentially reduced the leverage in the financial markets and returned yields for both stocks and bonds to more compelling levels. Our bond sub-advisers believe that the market is oversold based on fundamentals, and are taking advantage of the volatility.

For context, although the size of the daily price moves is significant, the recent downturn simply brings stock prices back to levels of two months ago. In regard to bonds, Treasury yields are at levels of 3 years ago – a more substantial decline. However, with muted economic growth prospects, labor weakness, and the need for further global deleveraging, we believe that the yields for U.S. Treasury and corporate debt are relatively compelling, particularly vs. other less liquid, developed market yields.